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Economic Incentives for Environmental Regulation

This paper, prepared for The New Palgrave Dictionary of Economics and the Law, provides a summary of the theory and the reality of economic-incentive approaches to environmental regulation. The paper begins with a derivation of the necessary and sufficient condition for a policy instrument to be cost effective, namely that the instrument induces all sources to abate emissions at the same marginal cost. Subsequent sections introduce economic-incentive policy instruments, including emission charges and tradeable permits, and show that these instruments, in theory, meet the specified condition. Then, six U.S. applications are described: EPA's emissions trading program; the leaded gasoline phasedown; water quality permit trading; the CFC phaseout; the SO2 allowance system; and the RECLAIM program. Reasons for the limited use of incentive-based instruments are examined, including the role of interest groups; ambivalence by regulated firms; and consumers' perspectives. Reasons for the mixed record of implemented instruments are also examined: inaccurate predictions; design problems; and limitations in firms' internal structures.